Will Higher Taxes Cost Jobs?

The debate about taxes in Washington is always the same: raising taxes will cost jobs. But what does history say about the subject? Will higher taxes cost jobs? Is there empirical evidence to support the claim?

Before we dig in too far I must point out I am not supporting one political party over the other, nor am I advocating for higher taxes. I merely point out historical facts on how tax increases affect job growth. No nasty emails, please. Respectful comments can be added below.

Income taxes in the United States began with the Civil War and were declared unconstitutional shortly after the war. World War I brought heavy financial demands on the Treasury, so an amendment was added to the Constitution allowing income taxes as we know them today. Income taxes started in 1913 and have continued unabated to today.

The first real opportunity to reduce income taxes significantly was after WWI. Major tax cuts to the top marginal tax rates in the mid 1920's lead to rapid growth in the economy. In a few years the over-heated, over-producing nation suffered a hangover called The Great Depression. The lesson learned is that lower top marginal tax rates provide a short-term boost to the economy followed by significant economic pain caused by the encouraged ramp-up in production. The lower rates encouraged current demand and sucked up future demand until a long recession was needed to work through the excesses.

Closer to home, President Kennedy reduced the top tax bracket from 90% to 70%. The 1960's were mostly good economic times. The economic issues of the 1970's were more related to demographics, expansion of the money supply during the Vietnam War, and oil shocks. Lowering marginal tax brackets that are very high seem to work long and short term.

President Reagan lowered top marginal tax brackets, too. Heavy emphasis was placed on encouraging supply by allowing fast expensing of assets for businesses. The economy boomed as employment increased and inflation dropped. The federal government ran large budget deficits during the entire period. If Social Security had the lower surpluses of today, President Reagan's deficit spending would have exceeded the rate of today's as a percent of GDP. The stock market crashed in 1987 by 22% in one day, the largest percentage drop on record. The economy only slowed without a recession and accelerated into the end of the decade before giving way to a real recession.

Like today, the 1990's saw a Democratic president and a Republican Congress from President Clinton's first midterm elections. Deficit spending that was acceptable to the Republicans under Reagan and Bush were untenable under Clinton. A tax increase coupled with spending cuts set the federal government up for the largest budget surpluses ever. But higher taxes did not kill the economy. Rather, the economy boomed with job growth, corporate profits, and the stock market walking hand in hand. Tax increases did not kill jobs in the 1990's because the top marginal tax rate was increased to 39.6%, a historically low top marginal tax rate.

Once Clinton left office, the newest Bush presidency set out to lower taxes by a massive amount. Deficit spending was back in place. More tax cuts over the first six years of George W. Bush created only a modest number of new jobs while expanding debt, public and private. By the end of the first decade of the Twenty-First Century the economy was in shambles, government receipts declining, job losses exceeding those created over the previous six years, and  nothing seemed to shake the sluggishness that set in.

Lower taxes did not help create jobs in the 2000's; slightly higher taxes gave us a job creating juggernaut in the 1990's. The tax code today has so many moving parts no one person understand the entire beast. Deductions and credits exist for every possible activity. Raising taxes by reducing deductions and credits should reduce the cost of complying with the tax code for individuals and businesses.

So the question remains: If we raise taxes will it cost jobs? It seems to me that a modest tax increase or a reduction in certain tax credits could actually encourage job growth. Any real effort to reduce Washington's red ink will require spending cuts and revenue increases.

Simplification of the tax code would provide real encouragement for businesses to hire. Businesses and individuals spend too much unproductive time gaming the tax system. A simpler tax code with fewer deductions and credits would allow certain tax rates to decline, especially for the middle class.

Remember, raising taxes are the thing to do as long as it is not my taxes being raised.

I Don't Have to Pay My Loans Either

My wife and I have an ongoing spat. (OK, I am making it up to make a point.) The argument is centered around how much we should spend on certain items in our family budget. I think we should fill the fridge with food, fund the retirement accounts, and invest for the kid's college fund. I am willing to work a few more hours to pay for these things.

My wife thinks I'm an idiot. She can't wait to move my tail out of the house and bring in a husband that thinks like she does. She says we should work even fewer hours and cut spending. Who cares about college and retirement so far in the future. As for the leaking roof, my wife thinks a patch is better than replacement. Since she holds the checkbook, she refuses to pay the credit card bill and mortgage until I agree with her and cut our income and spending. I tell her she is nuts. She says she called the mortgage and credit card company and they were fine with us paying late if it helped us get out financial house in order.

The above example is exactly how Congress is acting with the debt ceiling limit. Wisconsin Rep. Paul Ryan says he talked with U.S. debt holders and was told a late payment is fine, especially if it leads to more fiscal responsibility later.

Back to our example. The due date for the credit card comes and goes without payment. Two weeks later the wife and I kiss and make up. The credit card is paid. No harm, no foul. Right?

Wrong! The bank now knows we are willing to leave bills unpaid even when we have the money to pay. The money was available to pay the credit card. We just chose not to pay it until we agreed to get along. The bank IS okay with the late payment because the interest rate was hiked from 8% to 18%. It will stay that way for years even with no future late payments.

Back to the real world. Do you really think U.S. debt holders will be fine with a missed or late interest payment? To a point, maybe. But really? No. Debt holders will now need a higher rate to compensate for the risk. Not just the risk of hard economic times, but lover's spats, too. Treasurys will no longer be the premium cash management tool they once were. All Americans will pay the price then for the stupidity of Congress and for a long time.

The Republicans and Democrats in Congress need to stop acting like an old married couple with an ax to grind and start acting like the professionals the American people thought they hired to run the country. Americans, and the world, are counting on it.

Second Chances

It looks like we the people will get a second chance to get our finances in order. Before year-end the tax bill that extends the Bush tax cuts for two additional years plus a payroll tax deduction of 2% should make it into law. This provides a massive opportunity for all of us to shore up our financial position.

The proposed tax bill will keep things like the child tax credit at $1,000 per child and lower tax brackets for income, qualified dividends, and long-term capital gains. In addition to the long list of extended lower taxes, the payroll tax will be reduced 2%. The payroll tax consists of Social Security (6.2%) and Medicare (1.45%). Your employer pays another 7.65% as well. The payroll tax deduction is a reduction of the Social Security portion from 6.2% to 4.2% for the employee only. This is a $1,000 tax deduction for someone earning $50,000 per year. You will see the additional money on each paycheck. If passed, the payroll tax deduction is for 2011 only.

Your Social Security benefits will not change due to the reduced payroll tax. The government will fund the Social Security Trust Fund from the general budget which means they will borrow the money to pay the trust fund.

Many Americans still have a personal finance mess on their hands. Years of overspending lead to a negative savings rate and high debt levels. The current low tax environment coupled with low interest rates is the perfect opportunity to pay down debt as fast as possible. It is only a matter of time before interest rates climb. Taxes must go up eventually to balance the books in Washington.

The debate about higher taxes is just that, a debate. The government is not taxing enough to cover Social Security, Medicare, Military, and interest. Defaulting on the national debt is out of the question as it would turn the U.S. into a third world country; Social Security and Medicare are sacred cows; and you can cut the military only so far before national security is at risk. Ergo, taxes will rise at some point in the future, whether they be income taxes or a value added tax.

It is easier to pay down debt when tax rates are low. When you keep more of what you make there is more available to reduce debt.

It is easier to pay down debt in a low interest rate environment. Payments apply more to debt and less to interest in such an environment.

If you have little or no debt, now is the time to build reserves for the day when interest rates rise. Tax policy can help you build that reserve faster and bigger.

Opportunity is knocking once again. It is wise to take advantage. The opportunity will not last forever.

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Without debt your income goes a long ways.